Question 1

Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate.Both companies are small,so they are not subject to the interest deduction limitation.Based on the data given below,how much higher or lower will HD's ROE be versus that of LD,i.e. ,what is ROEHD - ROELD? Do not round your intermediate calculations. ​

Accepted Answer

A)   5.62%
B)   4.02%
C)   6.69%
D)   5.35%
E)   5.09% D

Question 2

Companies HD and LD have identical amounts of assets,investor-supplied capital,operating income (EBIT),tax rates,and business risk.Company HD,however,has a higher debt ratio than LD.Company HD's return on investors' capital (ROIC)exceeds its after-tax cost of debt,rd(1 - T).Which of the following statements is CORRECT?

Accepted Answer

A)   Company HD has a higher return on assets (RO
A)  than Company LD.
B)   Company HD has a higher times interest earned (TI
E)  ratio than Company LD.
C)   Company HD has a higher return on equity (RO
E)  than Company LD,and its risk as measured by the standard deviation of ROE is also higher than LD's.
D)   The two companies have the same ROE.
E)   Company HD's ROE would be higher if it had no debt. C

Question 3

Which of the following statements is CORRECT?

Accepted Answer

A)   If Congress lowered corporate tax rates while other things were held constant,and if the Modigliani-Miller tax-adjusted theory of capital structure were correct,this would tend to cause corporations to decrease their use of debt.
B)   A change in the personal tax rate should not affect firms' capital structure decisions.
C)   "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt,while business risk reflects both the use of debt and such factors as sales variability,cost variability,and operating leverage.
D)   The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC,and (3) maximizes its EPS.
E)   If changes in the bankruptcy code made bankruptcy less costly to corporations,this would likely reduce the average corporation's debt ratio. A

Question 4

Modigliani and Miller (MM)won Nobel Prizes for their work on capital structure theory.

Accepted Answer

A) True 
 B)False

Question 5

Which of the following statements is CORRECT?

Accepted Answer

A)   A firm's business risk is determined solely by the financial characteristics of its industry.
B)   The factors that affect a firm's business risk include industry characteristics and economic conditions,both of which are generally beyond the firm's control.
C)   One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy.
D)   A firm's financial risk can be minimized by diversification.
E)   The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business risk.

Question 6

A firm's business risk is largely determined by the financial characteristics of its industry,especially by the amount of debt the average firm in the industry uses.

Accepted Answer

A) True 
 B)False

Question 7

Firms U and L each have the same amount of assets,investor-supplied capital,and both have a return on investors' capital (ROIC)of 12%.Firm U is unleveraged,i.e. ,it is 100% equity financed,while Firm L is financed with 50% debt and 50% equity.Firm L's debt has an after-tax cost of 8%.Both firms have positive net income and a 35% tax rate.Which of the following statements is CORRECT?

Accepted Answer

A)   The two companies have the same times interest earned (TI
E)  ratio.
B)   Firm L has a lower ROA than Firm U.
C)   Firm L has a lower ROE than Firm U.
D)   Firm L has the higher times interest earned (TI
E)  ratio.
E)   Firm L has a higher EBIT than Firm U.

Question 8

Southeast U's campus book store sells course packs for $15.00 each,the variable cost per pack is $12.00,fixed costs for this operation are $300,000,and annual sales are 110,000 packs.The unit variable cost consists of a $3.00 royalty payment,VR ,per pack to professors plus other variable costs of VO = $9.00.The royalty payment is negotiable.The book store's directors believe that the store should earn a profit margin of 10% on sales,and they want the store's managers to pay a royalty rate that will produce that profit margin.What royalty per pack would permit the store to earn a 10% profit margin on course packs,other things held constant? Do not round your intermediate calculations.

Accepted Answer

A)   $1.77
B)   $1.74
C)   $1.72
D)   $1.83
E)   $2.22

Question 9

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.However,that article was criticized because it assumed that no taxes existed.MM then revised their original article to include corporate taxes,and this model led to the conclusion that a firm's value would be maximized if it used (almost)100% debt.

Accepted Answer

A) True 
 B)False

Question 10

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.

Accepted Answer

A) True 
 B)False

Question 11

Gator Fabrics Inc.currently has zero debt .It is a zero growth company,and additional firm data are shown below.Now the company is considering using some debt,moving to the new capital structure indicated below.The money raised would be used to repurchase stock at the current price.It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat,as indicated below.If this plan were carried out,by how much would the WACC change,i.e. ,what is WACCOld - WACCNew? Do not round your intermediate calculations. ​

Accepted Answer

A)   3.33%
B)   3.00%
C)   2.55%
D)   3.63%
E)   2.40%

Question 12

You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer.The issue now is how to finance the company,with only equity or with a mix of debt and equity.Expected operating income is $620,000.Other data for the firm are shown below.How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity,i.e. ,what is EPSL - EPSU? ​

Accepted Answer

A)   $1.50
B)   $2.08
C)   $1.91
D)   $1.67
E)   $1.58

Question 13

If two firms have the same expected earnings per share (EPS)and the same standard deviation of expected EPS,then they must have the same amount of business risk.

Accepted Answer

A) True 
 B)False

Question 14

Senate Inc.is considering two alternative methods for producing playing cards.Method 1 involves using a machine with a fixed cost (mainly depreciation)of $12,500 and variable costs of $1.00 per deck of cards.Method 2 would use a less expensive machine with a fixed cost of only $5,000,but it would require a variable cost of $1.50 per deck.The sales price per deck would be the same under each method.At what unit output level would the two methods provide the same operating income (EBIT)?

Accepted Answer

A)   17,100
B)   15,300
C)   15,000
D)   12,750
E)   13,500

Question 15

The Miller model begins with the Modigliani and Miller (MM)model with corporate taxes and then adds personal taxes.

Accepted Answer

A) True 
 B)False

Question 16

Your firm's debt ratio is only 5.00%,but the new CFO thinks that more debt should be employed.She wants to sell bonds and use the proceeds to buy back and retire common shares so the percentage of common equity in the capital structure (wc)= 1 - wd.Other things held constant,and based on the data below,if the firm increases the percentage of debt in its capital structure (wd)to 60.0%,by how much would the ROE change,i.e. ,what is ROENew - ROEOld? Do not round your intermediate calculations. ​

Accepted Answer

A)   31.23%
B)   26.98%
C)   30.32%
D)   34.56%
E)   26.07%

Question 17

If a firm utilizes debt financing,a 10% decline in earnings before interest and taxes (EBIT)will result in a decline in earnings per share that is larger than 10%,and the higher the debt ratio,the larger this difference will be.

Accepted Answer

A) True 
 B)False

Question 18

Assume that you and your brother plan to open a business that will make and sell a newly designed type of sandal.Two robotic machines are available to make the sandals,Machine A and Machine B.The price per pair will be $25.50 regardless of which machine is used.The fixed and variable costs associated with the two machines are shown below.What is the difference between the break-even points for Machines A and B? Do not round your intermediate calculations.(Hint: Find BEB - BEA) ​

Accepted Answer

A)   3,762
B)   3,135
C)   2,640
D)   3,564
E)   3,300

Question 19

Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

Accepted Answer

A) True 
 B)False

Question 20

A major contribution of the Miller model is that it demonstrates,other things held constant,that

Accepted Answer

A)   personal taxes increase the value of using corporate debt.
B)   personal taxes lower the value of using corporate debt.
C)   personal taxes have no effect on the value of using corporate debt.
D)   financial distress and agency costs reduce the value of using corporate debt.
E)   debt costs increase with financial leverage.

Exam 14: Capital Structure and Leverage

Which of the following statements is CORRECT?

Modigliani and Miller (MM)won Nobel Prizes for their work on capital structure theory.

Which of the following statements is CORRECT?

A firm's business risk is largely determined by the financial characteristics of its industry,especially by the amount of debt the average firm in the industry uses.

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.

If two firms have the same expected earnings per share (EPS)and the same standard deviation of expected EPS,then they must have the same amount of business risk.

The Miller model begins with the Modigliani and Miller (MM)model with corporate taxes and then adds personal taxes.

If a firm utilizes debt financing,a 10% decline in earnings before interest and taxes (EBIT)will result in a decline in earnings per share that is larger than 10%,and the higher the debt ratio,the larger this difference will be.

Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

A major contribution of the Miller model is that it demonstrates,other things held constant,that